Can You Really Beat The Market?

If you wanted to invest in shares, but didn’t think you could beat the market, you’d only need to follow a pretty simple strategy. All you’d do is invest in an exchange trade fund (ETF) that replicates the index.

It’s a competitive part of the market. A popular ETF based on the S&P/ASX 200 might only charge around 0.15% per annum. For a small fee, you’ll know that the ETF will generate the market return.

Plus, you won’t have to spend countless hours sifting through research reports, or sweating over annual results.

With the majority of active managers worldwide failing to match the performance of their respective indices (let alone beat them), the ETF sector is one that only continues to grow.

Despite their underperformance over the last three to five years, though, investors continue to park their funds with active managers. Investors expect these active funds to beat the market, but how are these managers supposed to go about it?

Active shares

If you want to beat the market, the one thing you can’t do is copy it. That is, you have to invest in stocks that aren’t in the index, or stocks that are in the index, but apply a different weighting.

The difference between the two is called the ‘active share’ part of the portfolio. This refers to shares in the actively-managed portfolio that aren’t in the index portfolio. The higher the correlation (the lower the ‘active share’) between the two portfolios, the harder it is to beat the market.

If you apply the same logic, you’d expect the chances of beating the market to improve with an increase in the active share part of the portfolio. But this doesn’t necessarily hold, either, as there’s no guarantee that those stocks outside the index will outperform.

Another challenge for the bigger funds is that those stocks outside the index might be too small and illiquid for them to invest in. The 200 companies included in the ASX 200 make up around 80% of the entire market’s capitalisation.

Also, the companies outside the index are relatively unknown and uncovered by the major broking houses. It might prove hard finding accurate analysis.

And, even if they have the best available analysis on small-caps, sometimes the market still leaves this segment behind. That is, the mega-caps power away, like they have since November last year.

It’s all in the weightings

That leaves active mangers tinkering away at the weightings of shares inside the index. If you take a look at the following table, you’ll see the limitations facing active managers. The table shows the breakdown of sectors in the ASX 200, as reflected in iShares Core S&P/ASX 200 ETF [ASX:IOZ].

It’s a pretty well-worn story that the financial sector makes up the biggest weighting in the ASX 200 index. As the table shows, this weighting is over 38%, with the Big Four banks making up around 30% by themselves.

Due to its weighting, this financial sector is the biggest stumbling block to beating the market. An active fund manager could make the right calls in the REIT or healthcare sectors, for example, but get swamped if they get the financial sector wrong.

The added complication is the degree of correlation between the major four banks. Although their exposure to different parts of the market varies (residential, commercial and international, for example), they are all directly exposed to the performance of the economy.

It’s unlikely that one would markedly outperform the others should the economy run into trouble. If that happens, though, the market might gravitate towards the bank stock they perceive to be the strongest.

Doing so might help manage losses in the portfolio, but isn’t going to help an active manager beat the index. And that is why it’s so challenging.

To illustrate the dilemma, let’s consider two of the Big Four banks — ANZ Banking Group [ASX:ANZ] and Commonwealth Bank [ASX:CBA].

When the market was getting sold off heavily at the start of 2016, the perception was that CBA was the stronger of the two.

At the time, ANZ traded as low as $22.00, while CBA was around $70. Since then, though, ANZ has risen over 45% (to around $32), while CBA has increased by only half that — around 23% (to $86).

To outperform, an active manager would have needed to reduce their CBA holdings at that time and rotate into ANZ. Something much easier to have done in hindsight than it would have been in the midst of the turmoil back then.

Beating the market is possible, because there are always some managers who do it. But it’s much harder than it looks. It requires a fund manager making a positive call on a stock (or sector) when everyone else is getting out.

But if they do get it right — think turnarounds like BHP Billiton [ASX:BHP], Fortescue Metals Group [ASX:FMG] and ANZ over the last year or two — and they do beat the index, it puts the manager in pretty rare territory.

The Daily Reckoning's mission is to look at the investment world and the financial world in a sceptical and contrarian way. To do that day in and day out and tell you honestly what we see, even if it isn't always popular. If you'd like to subscribe to an alternative look at the mainstream interpretation of events, join for free here.